International Income Taxation Chapter 13: DIRECT INVESTMENT ABROAD Professors Wells

Presentation:

April 23, 2014

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Chapter 13 – Direct Investment Abroad p. 1073

Alternative foreign investment situations: Cf., Direct vs. Portfolio Investment Alternative direct investment structures: 1)  Foreign branch of a U.S.

corporation (or a foreign branch of a U.S. subsidiary)

2)  Foreign country subsidiary 3)  Third country (foreign) subsidiary

(and branch in the destination country?).

US Parent

Foreign Subsidiary

Worldwide Taxation

Deferral Privilege?

Foreign Branch

Consolidate

Source Country Taxation

Foreign Subsidiary

Foreign Branch

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Foreign Branch Options p. 1073

Use (i) U.S. parent corporation or (ii) a special purpose U.S. (or foreign) subsidiary. General Thoughts on “Branches’

1)  Branch will enable U.S. tax deductions, e.g., minerals and oil and gas exploration and

2)  Branch will enable consolidated return treatment (loss utilization, but “recapture”).

3)  No limitation of liability for foreign branch assets – but, use a special purpose U.S. subsidiary for only holding this investment.

US Parent

Foreign Subsidiary

Worldwide Taxation

Deferral Privilege?

Foreign Branch

Source Country Taxation

Foreign Subsidiary

Foreign Branch

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Use of a Foreign Business Corporate Organization p. 1076

If a corporation, deferral of U.S. income tax is available, assuming inapplicability of Subpart F (e.g., if active business operations and tax holidays in the foreign country). Organization of a foreign corporation may accommodate joint foreign investors. What form of foreign business entity should be used to enable corporate status? LLC? Use a “hybrid entity” or a corp. in the foreign country?

US Parent

Foreign Subsidiary

Worldwide Taxation

Deferral Privilege?

Foreign Branch

Source Country Taxation

Foreign Subsidiary

Foreign Branch

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Problem p. 1078 Basic Assumptions

Western (U.S.) is engaged in U.S. mining. Planning a mining venture in Country Z. Initial capital of $300 million in equity. Terms of the “deal” in the foreign country: Royalty to be paid for the mineral product; Foreign income tax of 30% on net profits; No withholding tax on div. or royalties; Deduction for royalty for process patent.

US Parent

Foreign Subsidiary

Foreign Branch

Country Z Tax: Profit before royalty $50,000,000 Royalty < 5,000,000> Net profit 45,000,000 Country Z income tax( 30%) <13,500,000> Profit after Country Z tax $31,500,000

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Problem p. 1078 Tax/Financial Analysis

Use a branch of the U.S. corporation or a foreign corporation?

US Parent

Foreign Subsidiary

Foreign Branch

Country Z Tax: Profit before royalty $50,000,000 Royalty < 5,000,000> Net profit 45,000,000 Country Z income tax( 30%) <13,500,000> Profit after Country Z tax $31,500,000

E&P/(General) Taxes(General) $31,500,000 13,500,000 <15,000,000> <6,428,571> $16,500,000 7,071,429

Subsidiary Analysis ($5 million royalty)

Royalty $5,000,000 Dividend & §78 Gross-up $21,428,571 US tax b/4 credits $9,250,000 §902 Credits $6,428,571 Residual US Tax $2,821,429

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Problem p. 1078 Tax/Financial Analysis

US Parent

Foreign Subsidiary

Foreign Branch

Country Z Tax: Profit before royalty $50,000,000 Royalty <5,000,000> Net profit 45,000,000 Country Z income tax( 30%) <13,500,000> Profit after Country Z tax $31,500,000

E&P(General) Taxes(General) 31,500,000 13,500,000 <15,000,000> <6,428,571> 16,500,000 5,785714

Branch Analysis ($5 million royalty) Western/Process Tax Analysis: Royalty $5,000,000 Earnings after royalty $45,000,000 *Percentage depletion <22,500,000> Taxable Income $27,500,000 US tax b/4 credits $ 9,625,000 §901 Credits <13,500,000> Residual US Tax -0- Excess Credits $3,875,,000

Note: This percentage depletion deduction is only given to US taxpayers, not to CFCs. The existence of this “extra” US deduction creates an exception to the general rule that low-taxed income achieves a lower US tax cost if earned in a CFC.

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Tax Characterization of the Foreign Business Entity p. 1079

Necessary to have limitation of liability? Use a corporation or a (non-corporate) LLC? Necessary to have two or more owners for an LLC? Use two special purpose subs in the U.S. to hold 50% (or 90 & 10%) interests. Deferral is not important if the foreign tax rate is high as or higher than the U.S. income tax rate.

US Parent

Foreign Subsidiary

Worldwide Taxation

Deferral Privilege?

Source Country Taxation

Foreign Subsidiary

Hybrid

Foreign Branch

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Entity Choices Outside the U.S. p. 1080

Foreign corporation in host country (and similar foreign counterparts). Third country corporation. Limited liability company (LLC). Limited partnership (LP). General partnership (GP). Contractural joint venture (JV).

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Entity Choices Outside U.S. – Business Law Aspects p. 1081

1.  Limitation of liability.

2.  Control arrangement.

3.  Profit sharing split.

4.  Foreign country tax burden.

5.  Foreign tax credit: (i) availability and (ii) excess FTC position for U.S. owner.

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Former §7701 Entity/Corp. Characterization Regs. p. 1082

OLD LAW 1)  Associates (both corp. or partnership). 2)  Objective to carry on business and divide the profits (both corp. or

partnership, not trust). 3)  Continuity of life – death, insanity or bankruptcy not causing

dissolution. 4)  Centralized management – non-owner may have continuing

authority to make management decisions. 5)  Free transferability of ownership interests – owners have power,

without the consent of other owners, to substitute others (not previously equity owners) for themselves in the organization;

6)  Limited Liability – no equity owner is personally liable for the debts of or claims against the organization.

Four Factor Test

Inconsistent classification possible: Hybrid entity – a corporation for foreign law purposes but a partnership for U.S. income tax purposes. Reverse hybrid (U.S. corp. status; foreign flow-through).

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“Check-The-Box” Entity – Characterization Regs. p. 1084

CURRENT LAW: Treas. Reg.§301.7701-1 through -3. Elective approach of structuring entities to be a (i) corporation or (ii) partnership for U.S. tax purposes. Permits the use of ‘hybrid entities”. Certain business entities are automatically classified as corporations for U.S. tax purposes, including a list of specific foreign entities. Reg. §301.7701-2(b)(8). Inconsistent Classification: now not only possible but straightforward. Easy to create hybrid and reverse hybrid entities.

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Foreign Business Entity Characterization p. 1087 If Eligible

Unless the foreign entity elects otherwise: 1)  Treated as association (and a corporation) if all members have

limited ability;

2)  Treated as a partnership if it has two or more members and at least one member does not have limited liability; or

3)  Disregarded as an entity separate from its owner if only a single owner that does not have limited liability.

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Change in Status of the Foreign Business Entity p. 1088

Federal income tax effects: 1)  Eligibility entity (partnership or disregarded entity) elects

corporate status – a §351 incorporation transaction.

2)  Eligible entity treated as a corporation elects partnership status – treated as a corporation liquidation and a contribution of assets to a partnership.

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Hybrid Entity Issues p. 1089 (Corp. / Disregarded Entity in Foreign Country)

USC (US)

FC #1 (Country A)

FC #2 (Country B)

Estimate: 45% Actual: 50%

Finance Co Actual Tax Rate: 5%

Manufacturing Actual Tax Rate: 40%

Second Example on p. 1093

Result: Manufacturing exception for FC #2 earnings and payments to FC #1 are non-events

Example on p. 1094 USC (US)

FC #1 (Country A)

FC #2 (Country B)

Estimate: 45% Actual: 50%

Buyer

Cash

Result: FC #2 share sales is treated as a sale of active business assets and thus not subject to FPHCI. Opens up “check & sell” planning. See Dover Case. p. 1095.

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Hybrid Branch & Possible Limitations p. 1090

Notice 98-11 – separate entity status for hybrids? Temporary Regs. – T.D. 8767. Seeks to treat hybrids as separate entities Notice 98-35 – withdrawing these items Proposed Regs. 1.954-9 (1999), pending (effective 5 years after finalized) Proposed “Extraordinary Transaction” Rule Withdrawal of this Rule – Notice 2003-46 Issue: Should IRS be able to promulgate a “branch rule” for FPHC income?

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JCT Staff Proposal p. 1097 Single Member Co.

Treat as a corporation for U.S. tax purposes the foreign entity which: 1)  Is a separate business entity organized under foreign law; and,

2)  Is a separate entity having only one member.

And, possible regs to preclude the division of ownership to avoid this corp. status rule.

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Dual Resident Corporations DCLS p. 1102

U.S. corporation is permitted to file a consolidated tax return with affiliated corporations. Losses of one group U.S. member can offset the income of another U.S. group member. §1504. Another country may treat the corporation as resident-management and control test. Dual resident corps cannot “double dip” for losses. §1503(d).

UK Parent (UK)

US Holdco (US)

US Target (US)

Bank

Interest Expense

Result: US Holdco (managed & controlled in UK but US corporation) is a dual resident, so its interest deduction is deducted in the UK consolidated return and the US consolidated return (double deduction).

Example on p. 1104

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Code §904 FTC Limitation & Planning Options p. 1110

Structuring of arrangements to enable reduction of overall effective foreign tax rate: 1)  Lending money and generating interest expense deduction and lower

withholding rate of the outbound interest payment.

2)  Export of goods – pass title to (i) generate foreign source income and (ii) avoid any income tax in the foreign jurisdiction.

3)  Technology licensing arrangement with the foreign subsidiary and extraction of low/no taxed, deductible royalty, to which the look-through rules are applicable for FTC.

4)  Managerial and technical services in foreign country – same planning objective, i.e., deductibility of payment for local country income tax and low/no withholding tax at source.

continued

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Capitalization of the Foreign Corporation p. 1112

Use debt or special class(es) of stock? Is the interest on the debt deductible for foreign country income tax purposes? And, FTC “look-through” rule. §904(d)(3). Debt arrangement enables the tax-free repayment of principal (not treated as dividend) and is free of the applicability of the withholding at source rules (if treaty). Cf., stock redemption subject to §302.

USC (US)

FC #1 (Country A)

FC #2 (Country B)

Finance Co Actual Tax Rate: 5%

Manufacturing Actual Tax Rate: 40%

Inte

rest

?

Below shows capitalization question: if deferral were the goal, then lend from FC#1. If repatriation is the goal, then can lend from USC.

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§367(d) Rules for Intangible Property Transfers p. 1114

Transfer of tangible property and intangibles as: 1)  Contribution to capital (consider §§351 & 367(d)) (ordinary

income), or

2)  Sale, lease or license (consider §482).

Consider (a) applicability of sourcing rules and (b) tax characterization rules – ordinary income or capital gain.

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